Cheap money is a signal that all is not well
With interest rates now at an all-time low, government bond markets have been perverted from a risk-free rate of return to a return-free rate of risk. This has never happened before. So how will it play out? The worrying answer is: nobody knows.
In her book, “Signals”, Dr Pippa Malmgren discusses the concept of “the return-free rate of risk. It is easy to dismiss the idea of outright price controls in the industrialised world. Nobody imagines these governments want to control the price of beef or chocolate, though they may concede such governments have an interest in the price of housing and wages.
No, instead, the governments of industrialised economies are intervening in the single most important price in any economy: the price of money. In the words of Friedrich Hayek:
Any attempt to control prices or quantities of particular commodities deprives competition of its power of bringing about an effective coordination of individual efforts, because price changes then cease to register all the relevant changes in circumstances and no longer provide a reliable guide for the individual’s actions (1).
Interest rates are about as low as they have ever been since the Roman Empire (2). What does the artificially low and subsidised price of money tell us about the future? It seeks to lure the public into borrowing money and making investments, which they would not otherwise do. It seeks to make the public take a bet on asset prices and on the future.
No price can be more important than the price of money itself. Government intervention to suppress interest rates perverts the bond market, which has serious consequences. Government bonds are supposed to constitute the risk-free rate of return against which all other investments are measured and judged.
This artificial control over money means that, far from being a risk-free rate of return, the government bond market can be perverted into a return-free rate of risk (3). It is return-free because interest rates are so low that holding bonds offers virtually no income (and increasingly negative income) to owners. Should the government’s effort fail at some point, should interest rates rise, the government would be the first to find it lacks the resources to repay its debt, other than relying on its ability to print its own money.
At the 2014 meeting of the American Economic Association, Bill Dudley, the President of the New York Fed, apparently said, “We don’t fully understand how large-scale asset purchase programmes work to ease financial market conditions” (4). In other words, QE (Quantitative Easing) is so innovative no one actually knows how it works or whether it works at all. Its end result is not yet known. Not enough time has passed. The facts are not in”.
(1). Friedrich Hayek, The Road to Serfdom, 1944.
(2). Sydney Homer and Richard Syalla, A History of Interest Rates, 2005.
(3.). Robert Jenkins (formerly on the Financial Policy Committee at the Bank of England), The Safety Catch, Financial World, July 2014.
(4). William Dudley, President and CEO Federal Reserve bank of New York, “Economics at the Federal Reserve Banks”, American Economic association 2014 Annual Meeting, Philadelphia, Pennsylvania, 4 January 2014.
Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Graeme
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“…… the governments of industrialised economies are intervening in the single most important price in any economy: the price of money.”
If only they were – we could then vote them out. Unfortunately many governments abdicated responsibility long ago and left it to a bunch of non-elected officials of questionable ability stubbornly sticking with policies that no longer work.
Roger Montgomery
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QE only works if you’re the only country doing it!!!!!!!
xiao fang xu
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“At the 2014 meeting of the American Economic Association, Bill Dudley, the President of the New York Fed, apparently said, “We don’t fully understand how large-scale asset purchase programmes work to ease financial market conditions” (4). In other words, QE (Quantitative Easing) is so innovative no one actually knows how it works or whether it works at all. Its end result is not yet known. Not enough time has passed. The facts are not in”.
It is always a good idea to pay attention to new words or phrases that seem to have no connection with any previous word or phrase, and which are not self-evident. Such a phrase these days is “quantitative easing.” When we hear a phrase like this, we should think through the implications of what this phrase probably means.
The new phrase may be a euphemism. A euphemism is a substitute phrase for a practice that is considered questionable or even wrong. The new phrase is substituted in order to tone down the contrast between what people regard as right and what they regard as wrong.
The phrase “quantitative easing” is a euphemism for monetary inflation. We are told that the Federal Reserve System or some other central bank may soon adopt a policy of quantitative easing. Whoever says this does not want to use the words “monetary inflation.” Why not? Because, when people hear the words “monetary inflation,” they think that this sounds bad. They think that it means that the government or the central bank is about to indulge itself by expanding the money supply. This is exactly what it does mean.
https://www.lewrockwell.com/2010/10/gary-north/youre-sitting-on-a-powderkeg/
According to the teachings of the Greek philosopher Parmenides, language illustrates human thinking (and reasoning); confused language is thus tantamount to confused thinking; confused thinking, in turn, provokes unintended acts and undesired outcomes
“Doublespeak” – a term that rose to prominence through the work of Eric Blair (1903–1950), more famously known as George Orwell – is a conspicuous form of confused language and thought. The term doublespeak was actually derived from the terms “newspeak” and “doublethink,” which Orwell used in his novel Nineteen Eighty-Four, published in 1949.
https://www.lewrockwell.com/2011/01/thorsten-polleit/the-many-euphemisms-for-moneycreation/
Angelo
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I’m not an economist but I do read widely on the subject, so I’m probably wrong and if so would appreciate a correction (or a link to an article for further reading).
Interest rates worldwide are low/negative because inflation is too low or negative, and has been so for many years. QE and ZIRP/NIRP have been tried as reflationary measures with limited success in various countries with side effects that include considerable market distortions (asset and bond bubbles among them). The next logical step is to try some form of helicopter money.
Used judiciously, HM would be a powerful tool to raise inflation, and thereby long term interest rates, to desirable levels. Australia used a form of HM in 2008 and I believe it was one of the (many) reasons we avoided the GFC. The main down side of HM is the danger of high inflation, and this danger seems more and more remote with every passing year. I don’t think we need HM in Australia yet, but our inflation and interest rates seem to be going the same way as the rest of the world. Japan should have tried it years ago, as well as several european economies. It seems to me some time in the next few years we may also hit the zero bound with interest rates, in which case we should not hesitate to use HM if inflation remains too low.
David Buckland
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Hi Angelo, interest rates worldwide are low/ negative because various Central Banks (European, Japanese, US) insist on purchasing Sovereign bonds at a price which does not reflect risk. Irrelevant of inflationary expectations, interest rates have never been lower. For example, would you lend the Italian Government money for ten years, earning 1.1 per cent per annum, when you know their underlying banking sector (which represents 2.5X their economy) is in poor financial shape and their Government has net debt to GDP of 136%? I’m don’t fully understand helicopter money, but I do know poor capital allocation decisions are eventually punished by risk-averse profit-driven buyers and sellers.
Greg McLennan
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I like that phrase “a return free rate of risk”, it sums things up pretty well, I think. But where will this experiment end? I don’t know. My gut feel suggests the word “badly” will be in there somewhere.
Another poster made the comment here a day or two back to the effect that these trends go on for longer than you expect and I think that might be the case here. The main reason is that I think that policy makers and central bankers will try to soften the blow as much as possible, by any means as possible, for as long as possible. I don’t think that any politician or central banker wants to be the one to put their hand up and say “We’re just going to let nature (the market) take its course, saddle up for the ride”. So, things could bump along more or less as is for a while. However I take the point that this is not “the new normal” and sooner or later things will change, and possibly abruptly, eventually.
David Buckland
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Thanks Greg. I think negative interest rates are putting a lot of pressure on many European Banks’ profitability and this may threaten their solvency by leaving them with little margin to absorb any shocks. That is one reason the Italian Banks share prices, for example, have declined by an average 65% over the past year. And throw in the fact Global Public plus Private Sector Debt is now approaching 300% of GDP (US$215t/ US$73t), significantly more than during the GFC of eight years ago.